Wednesday, October 31, 2012

Passarelli, Trading Option Greeks, 2d ed.

If you want to trade options, you have to know the greeks. You may not use them as primary inputs in your everyday trading, but if you don’t have a handle on them there will come a time that you’ll suffer mightily. In this second edition of Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg/Wiley, 2012) Dan Passarelli offers what one might describe, co-opting (and abusing) option language, as a preemptive strike.

He first explains the basics of the greeks and how they interact, then moves on to spreads (vertical, wing, and calendar and diagonal), volatility (especially in the context of delta-neutral trading), and advanced option trading (straddles and strangles, ratio spreads and complex spreads).

For retail traders, at least for those without large portfolios, the first two parts of the book (the basics and spreads) will probably be the most valuable, although the third and fourth parts are must reads for everyone.

Passarelli does an excellent job of explaining the greeks, complete with tables and graphs. Take gamma, for instance. What does a 7-day call gamma graph look like as opposed to a 92-day call gamma? “As expiration draws nearer, the gamma decreases for ITMs and OTMs and increases for the ATM strikes.” And what happens if we raise the volatility assumption? It “flattens the curve, causing ITM and OTM to have higher gamma while lowering the gamma for ATMs.” In brief, “Short-term ATM options with low volatility have the highest gamma. Lower gamma is found in ATMs when volatility is higher and it is lower for ITMs and OTMs and in longer-dated options.” (p. 37)

Or how do the greeks come into play with the single-legged trades—buying or selling calls or puts? Here Passarelli illustrates the impact of the greeks with multiple trade examples. Some of his fictional traders are faced with specific problems such as how far the stock price can advance before the calls are at 1.10. Or what is the likelihood of an option’s gaining value from delta against the risk of theta erosion if one holds the trade for 35 days?

After two chapters on put-call parity and synthetics and dividends and option pricing, Passarelli turns to spreads. He describes credit and debit spread similarities, explains why strike selection is essential for a successful condor, and maintains that calendar-family spreads, which are “veritable volatility spreads, … allow traders to take their trading to a higher level of sophistication.” (p. 233)

The rank novice will probably find this book overwhelming. But anyone with even a couple of months of exposure to options will find it enlightening. Every option trader who doesn’t have the greeks down cold would do themselves a favor by reading Passarelli’s book.

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